Wednesday, July 11, 2007

Cap and Trade: Bingaman/Specter

The WSJ.com Real Time Economics blog had a post a couple days ago regarding a letter the Congressional Budget Office sent Senator Bingaman, who had requested clarification of the CBO's Issue Brief on carbon Cap-and-trade proposals. The CBO had taken a dim view of C&T in the brief.

Real Time Economics highlighted some key points:

The CBO makes it clear that the broader effects of a cap-and-trade program will depend on how the policy is implemented. The program would lead to higher prices for energy and energy-intensive goods no matter how it is implemented, placing a higher burden on low-income households. But that burden could be offset by how allowances are handled.

The allowances “would be worth tens or hundreds of billions of dollars.” If they are given freely to companies that emit carbon dioxide, they are likely to result in windfall profits and offset losses the companies experience from the caps. At the same time, if they are sold, the government could offer rebates to taxpayers that would offset the impact of higher energy costs.

The CBO concludes that “because giving allowances to energy producers would disproportionately benefit higher-income households and would preclude the possibility of using the allowance value to reduce taxes on capital and labor, such a strategy would appear to rate low from both a distributional and an efficiency perspective.”

The following are the key points about distributional and efficiency effects:

A cap-and-trade program would lead to price increases for energy and energy-intensive goods. Such price increases would occur regardless of whether the government sold the allowances or gave them away, and they would impose a larger burden (relative to income) on low-income households than on high-income households. Those price increases are essential to the success of a cap-and-trade program because they are the most important mechanism through which businesses and households are encouraged to make investments and behavioral changes that reduce CO2 emissions.

The policy-induced price increases would reduce demand for energy and energy-intensive goods and services, resulting in losses to some current investors and workers in those sectors (who could see their stock values decline or could face employment risks as jobs in those sectors were reduced). Stock losses would tend to be widely dispersed among investors, because shareholders typically have diversified portfolios. In contrast, the costs borne by existing workers would probably be concentrated on relatively few households, and by extension, their communities.

The price increases and the potential losses to investors and workers are only part of the story, however. The allowances would be worth tens or hundreds of billions of dollars. Policymakers' decisions about how to allocate them would determine the ultimate distributional impact of the policy, which would reflect both households' losses from price increases, stock declines, and job losses as well as any gains to households from the allocation method (such as described below). Furthermore, decisions about how to allocate allowances could affect the near-term costs that the program would impose on the economy.

If they chose to do so, lawmakers could more than offset the price increases experienced by low-income households or the costs imposed on workers in particular sectors of the economy. They could do that by selling some or all of the allowances and using the revenue to compensate specific households or entities.For example, CBO found that lower-income households could be better off as a result of a cap-and-trade program (compared with no program) if the government chose to sell the allowances and used the revenue to pay an equal lump-sum rebate to each household in the United States. In that case, the size of the rebate would be larger than the average increase in low-income households' spending on energy and energy-intensive goods. High-income households would be worse off under that scenario because their average increase in spending would be larger than the rebate.

By contrast, CBO found that giving all or most of the allowances to energy producers to offset potential losses by investors in those industries—as was done in the cap-and-trade program for sulfur dioxide emissions, which cause acid rain—would exacerbate the regressivity of the price increases. On average, the value of the CO2 allowances that producers would receive would more than compensate them for any decline in profits caused by a drop in the demand for energy-intensive goods and services.As a result, the companies that received the allowances could experience "windfall" profits. Because those profits would not depend on how much a company produced, however, they would be unlikely to prevent the declines in production and resulting job losses that would stem from the price increases. In addition, those profits would accrue to shareholders, who are primarily from higher-income households, and would more than offset those households' increased spending on energy and energy-intensive goods and services. Low-income households, by contrast, would benefit little if allowances were given to energy producers for free, and they would still bear a disproportionate burden because of price increases. Such an allowance-allocation policy would be "strongly regressive," in that higher-income households would be better off as a result of the policy and lower-income households would be made worse off.

Selling emission allowances would allow the government not only to compensate some households for their higher costs or workers for their lost jobs, but also to devote part of the sales revenue to reducing existing taxes that discourage economic activity (such as income or payroll taxes). Those tax reductions, like free allocations to energy producers, would tend to disproportionately benefit higher-income households. However, unlike free allocations, they would reduce the near-term cost that a cap-and-trade program would impose on the economy, perhaps substantially.

Because giving allowances to energy producers would disproportionately benefit higher-income households and would preclude the possibility of using the allowance value to reduce taxes on capital and labor, such a strategy would appear to rate low from both a distributional and an efficiency perspective.

HT to Phil Izzo at the WSJ.com's Real Time Economics blog for bringing the letter to our attention.